CV 2014 August 1 - 7
August 6 PRICE ELASTICITY OF DEMAND has tremendous application in pricing and marketing strategies of both businesses and government agencies measures how much consumers will increase/decrease their quantity demanded in response to a price change big change (flat slope) -> demand is elastic small change (steep slope) -> demand is inelastic PRICE ELASTICITY FORMULA: E = ( ΔQ/Q ) / (ΔP/P) 2 reasons for using % instead of absolute values: 1. use of percentage changes for both Q and P frees from worrying about unit of measure for different goods and unit of measure for price 2. allows to solve the Comparing Products Problem e.g: it makes little sense to compare the effects on Q of a $1 increase in the price of a $10000 car versus a $1 increase in the price of a $1 carton of milk -> products has risen by the same amount but price of milk has risen by 100% while price of car has risen by a miniscule tenth of 1% -> therefore, better to compare the price change of both products on the same percentage basis to determine how consumers will respond E = ( ΔQ/(Q1+Q2)/2 ) / (ΔP/(P1+P2)/2) --> dividing a change by an average since Q and P are inversely related, the price elasticity coefficient will always be a negative number but, economists usually ignore the minus sign and present price elasticities as absolute values MAJOR CATEGORIES OF ELASTICITY 1. Elastic given percentage change in P results in a larger percentage change in Q price elasticity > 1 horizontal demand curve: perfectly elastic 2. Inelastic price elasticity < 1 percentage change in P is accompanied by a relatively smaller change in Q vertical curve: perfectly inelastic 3. Unit elastic price elasticity = 1 e.g. 1% increase in P causes a 1% increase in Q WHAT DETERMINES ELASTICITY OF DEMAND luxuries vs necessities substitutability the greater the number of substitues, the more elastic its demand depends on how narrowly the product is defined proportion of income other things equal, the higher the price of a good relative to your budget, the greater will be your elasticity of demand for it time in general demand will tend to be more elastic in the longer run than in the short run August 5 OPTIMIZING BEHAVIOR given the money they have in their pockets consumers are going to find the best way to spend it all economic agents are assumed to optimize something as a way of explaining their behavior CONSUMER OPTIMIZATION consumers maximize utility subject to a budget or income constraint consumers have a certain amount of income to spend subject to their budget constraint and given a menu of prices they will choose a market basket of goods that will provide them with the greatest utility or satisfaction EQUIMARGINAL PRINCIPLE utility-maximizing rule a consumer with a fixed income facing market prices will achieve maximum satisfaction when the marginal utility of the last dollar spent on each good is exactly the same as the marginal utility of the last dollar spent on any other good --> marginal utility per dollar utility is maximized when the marginal utility of the last dollar spent on each good is exactly the same as the marginal utility of the last dollar spent on any other good DERIVING THE DEMAND CURVE equimarginal principle perfectly explains why demand curves slope downward rise in prices lead to less demanded quantity substitution effect: when the price of Dove Bars rises, Greg increases his consumption of Big Macs because last dollar spent on dove bar yields less utility than last dollar spent on big mac INCOME EFFECT difference between nominal income and real income nominal: face value of what we have in our pocket or bank account real: nominal income adjusted for inflation MUgood1/P1 = MUgood2/P2 = MUgood3/P3 = ... = MU per $ of income MUx/Px > MUz/Pz consume more of good x MUx/Px < MUz/Pz consume more of good z